End of Lockup Period for VA Linux Doesn't Feel Too Liberating / Stock is 85% below first-day close, but still above IPO price

Published 4:00 am, Wednesday, June 7, 2000

Today, employees at VA Linux and the venture capitalists who financed it get their first chance to sell shares in the company since it pulled off a record- breaking IPO six months ago.

But there probably won't be much celebrating.

That's because the stock has gone almost straight downhill since it soared 733 percent on its opening day.

And it could go down some more, now that there are more than four times as many shares that potentially can be traded. When the Sunnyvale company issues stock to acquire competitor Andover.net later this week, there will be even more VA Linux shares on the market.

The expiration of IPO lockup periods has gotten a lot of attention lately in the wake of last year's enormous surge in deals and this year's punishing decline in Nasdaq stocks.

When a company goes public, it typically sells 5 to 20 percent of its shares outstanding. Company insiders -- employees and financial backers -- own a lot of the remaining shares, but the investment bank usually prohibits them from selling their stock for 180 days.

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Restricting supply helps prop up a stock in its early days. In theory, after six months, the company will be strong enough to withstand the crush of a huge wave of new shares coming on the market. And in a good market, lockup periods go almost unnoticed. But in a weak one, investors look for any reason to sell stocks.

Many Silicon Valley employees have stood on the sidelines watching the value of their locked up shares shrivel. But few have felt the same pain as the folks at VA Linux.

On December 10, the little- known company, which makes hardware and software for the free Linux operating system, landed at the top of the front page of this very newspaper.

The day before, the company's stock, which was initially priced at $30 per share, opened at $299 and soared as high as $320 before closing at $250 in after-hours trading.

VA Linux was among a handful of money-losing companies, including Red Hat and Andover.net, that were swept up in a short-lived euphoria that Linux would challenge Microsoft in the OS market.

Its first-day day gain -- 733 percent -- is still a record, but it also proved to be a high-water mark for VA Linux.

The stock closed yesterday at $38.50, down $3.56.

Employees who got in at the IPO price are still above water. Venture capitalists and founders got in at even lower prices.

Pity the poor investors who bought on the open market. (Check out the chart on Page D10: Of the top 10 IPOs ranked by first- day performance, only one, Foundry Networks, is trading above its first-day close, adjusted for splits.)

What happens to VA Linux in the future depends mostly on its ability to turn a profit (the company is expected to do so at the end of next year) and the market's appetite for Linux stocks, which in turn depends on many factors, including the fate of Microsoft.

The big increase in share volume will also be a factor.

VA Linux sold 5.06 million shares in its IPO. That represents 11.5 percent of the company's 44.1 million shares outstanding. Today, 22.9 million of the outstanding shares will be unlocked and available for trading, with certain restrictions.

This week, VA Linux will complete its acquisition of Andover.net, another Linux company that went public two days before VA Linux and whose stock chart looks remarkably similar to VA Linux's.

VA Linux will issue 6.8 million shares to acquire Andover, bringing its total outstanding to 50.9 million.

How will the increase affect the share price?

"Recently, it has been very difficult to predict what will happen when lockups expire," says Phil Rueppel, an analyst with Deutsche Banc Alex. Brown. "Many employees and early investors believe the pullbacks in a lot of stocks like VA Linux are overblown. Given that, many of them choose to hold the stock. Also, given the price we've seen recently on VA Linux, it looks attractive for other investors to step up and accumulate the stock that some of the restricted shareholders might be distributing."

One new study shows that during the three-day window before and after a lockup expires, stocks on average lose 1.8 percent, net of any change in the overall market.

Gordon Hanka and Laura Field, assistant professors of finance at Penn State University, reached that conclusion after studying 2,000 companies that went public between 1988 and 1997. "We looked at 1999 and found the effect is still there," Hanka said.

Among firms financed by venture capital firms, the price drop is more pronounced and getting larger. It was 3 percent during the study period and 4 to 5 percent in 1999.

What's more, the decline is permanent, Hanka says.

Another finding: Trading volume increases dramatically on the day the lockup ends. "It rises to twice normal, just for a day or two, then it's permanently increased by 40 percent."

Hanka says the practical implications are: "Don't buy stock in a company a week or two before the lockup expires. And if you're going to sell, do it before the lockup ends."

He also warned that it's "difficult to make money by shorting these things, because the bid-ask spread is bigger than the average return."

You can find weekly lists of lockup expirations in the Wall Street Journal and on many financial Web sites.

One of the most useful sites is www.ipolockup.com, which provides not just a list of past and upcoming expirations, but also prices before and after the expiration and trading volume.

One interesting column is called "trading days to absorb new shares." This figure is the number of shares being released from lockup divided by average daily trading volume. The result is the number of trading days it would theoretically take insiders to sell all the unlocked shares, assuming no Rule 144 restrictions.

For VA Linux, this number is 71 days, which is reasonable compared with some other companies coming out of lockup, such as Fogdog (254 days) and Plastic Surgery Company (634 days).

Brad Alford, CEO of IPOLockup.com, hasn't researched his absorption rate but he says that based on anecdotal evidence, "if it's more than 100 days, it seems to affect the stock."